Since 2017 the Financial Conduct Authority (the “FCA”) has been consulting on various proposals to reduce the potential for harm to investors from the liquidity mismatch in open-ended property funds (i.e. UK authorised funds that invest directly in property such as shops, warehouses or offices). In the FCA’s latest consultation paper (CP20/15) (the “Consultation”), it is consulting on its proposal for new rules that would require investors of property funds to give notice, potentially of up to 180 days, before their investment is redeemed. As usual the FCA welcomes any feedback, especially on suggestions for alternative measures that might achieve the same outcome.
In 2017, the FCA launched a discussion paper (DP17/1) concerning the risks of illiquid assets in open-ended funds. As a result of the feedback that it received, the FCA consulted on and set out new rules in 2019 for open-ended funds investing in inherently illiquid assets (“PS19/24”) that came into effect from 30 September 2020. In summary, the new rules require investors to be provided with clear and prominent information on liquidity risks, and the circumstances in which access to their funds may be restricted. Managers of funds investing in inherently illiquid assets are also now required to maintain plans to manage liquidity risk.
In PS19/24, the FCA explained that they would consider the use of notice periods and reduced dealing frequency as liquidity management tools for open-ended funds that invest in illiquid assets that are offered to retail investors. Since the publication of PS19/24, the FCA has evaluated the liquidity of open-ended funds with the Bank of England (the “BoE”). The BoE’s December 2019 Financial Stability Report provided an update on the BoE’s concerns regarding open-ended funds that invest in illiquid assets (the “Report”). The Report recommended that there should be greater consistency between the liquidity of a fund’s assets and its redemption terms. As such, the BoE recommended that (i) redeeming investors should receive a price for their units that reflects the discount needed to sell the required portion of a property fund’s assets within the specified redemption notice period; and (ii) that redemption notice periods should reflect the time needed to sell the required portion of fund assets without discounts beyond those captured in the price received by the redeeming investor.
Following this Report, the FCA and BoE have engaged with a number of managers of property funds on possible options to address the risks with liquidity mismatch and set out their proposed approach in its Consultation.
WHO DO THE PROPOSALS AFFECT?
The new rules are only directly relevant to UK-authorised property funds that are non-UCITS retail schemes (“NURS”), primarily affecting the following:
- managers of UK authorised property funds, constituted as NURS;
- depositaries of these funds;
- feeder funds that invest in these property funds;
- master funds that invest in property, which these property funds invest in;
- ancillary service providers;
- providers of investment services offering access to these funds, including Self-Invested Personal Pension (SIPP) and Small Self-Administered Schemes (SSAS);
- providers, as well as Individual Savings Account (ISA) managers;
- distributors of these funds;
- investment intermediaries who advise on or invest in these funds;
- unit-linked insurers who offer insurance contracts linked to these funds;
- discretionary wealth managers, including those who offer model portfolios; and
- other professional or institutional investors.
The Consultation may also be of interest to managers of other types of UK property funds, managers of other UK authorised funds and investment managers who manage investments on behalf of UK authorised funds.
Open-ended funds let investors pool their contributions so they can invest efficiently, share in the profits or income made by the assets held by the fund, and have access to investment expertise. Investors can request to be issued new units and redeem units on demand. The issue highlighted by the FCA in its Consultation is that the underlying property in which the funds invest cannot be bought and sold at the same frequency as investors can buy and sell units. This in turn creates a liquidity mismatch.
To mitigate this liquidity risk, most managers hold significant cash balances so that they can pay investors if they are not able to sell the underlying property assets fast enough. If a property fund runs out of cash, this may lead it to suspend dealings in the units of the fund. As a consequence, this can cause investors to request their cash back in anticipation of such suspensions, potentially worsening the problem. This is what occurred in June 2019 in respect of the widely publicised LF Woodford Equity Income Fund, a prominent and popular authorised UCITS scheme, that suspended dealing and that was subsequently liquidated, causing significant loss to its investors.
The FCA is looking to specifically reduce the potential for investor harm that arises where the terms for dealing in units of a property fund are not aligned with the time that it takes to buy or sell the property assets that the fund invests in. The FCA is seeking to prevent the likelihood of liquidity runs on funds leading to “rapid sales” of assets which may disadvantage investors who remain in the fund. The FCA has termed this type of scenario as the ‘first mover advantage’.
To address the potential harm caused by the liquidity mismatch of NURS that invest directly in property, the FCA is proposing that investors must notify fund managers in advance that they want to redeem their investment. The FCA is proposing that when a fund receives a redemption request, the manager should wait for a period, in other words a notice period, after which they will process the redemption request.
The FCA has stressed that the notice period needs to be of sufficient length so that the manager can plan sales of property assets to meet redemptions as they fall due. This would mean that the manager is better able to plan when to invest or to make asset sales without needing immediately to meet any unexpected requests. The FCA also believes that this may mean that property funds could tolerate holding less cash than they do currently, enabling this money to be invested into property or other permitted assets. The Consultation sets out that the notice period would also send a clear signal to investors in these property funds that they are intended for medium-term to long-term investment. Therefore, future investors would better understand that these funds are not offering short-term liquidity returns.
Length of notice period
The FCA is consulting on the precise length of the notice period and is proposing between 90 and 180 days for these funds, but it is open to other notice periods. The FCA has done its due diligence, looking into both academic research and market practice on the length of time that a commercial property takes to sell. According to academic research, 60-90 days is the most common period for a property to be sold from the time it is first marketed, although the FCA notes the data is somewhat outdated.
From the perspective of the consumer, the FCA believes that 90 days is an acceptable timeframe for a consumer to plan their financial affairs, citing as an example that deposit takers generally offer term deposits which require 90 days’ notice. The FCA is also aware of the fact that 180 days may mean more time to sell a property at the best price, but can cause more issues for the consumer.
The Consultation does note that NURS currently are already required to redeem investors at least once every 185 days and as such notice periods cannot exceed this period of time.
Proposed dealing structure
The FCA proposed that relevant funds would operate the dealing structure as follows:
- each investor’s redemption request would be received and recorded, then processed at the end of a notice period;
- the investor would receive the value of their investment, based on the unit price of the fund at the first valuation point following the end of their notice period; and
- redemption requests would be irrevocable, so that investors cannot place orders and withdraw them before the end of the notice period if market conditions change (the FCA has commented that not including this step may lead to fund manager’s selling property to meet redemption requests that are subsequently cancelled, which is not ideal).
In terms of setting the redemption price, the FCA has suggested that the price of redemption is based on the first valuation of the fund at the end of the notice period, considering the market risk a fair way to balance the interest of all investors.
On this basis and dealing structure, the FCA believes that the proposed notice period would allow the manager to plan sales of property assets so that it could better meet redemptions that are requested. Moreover, the introduction of notice periods would enable greater efficiency of these products as fund managers would be able to allocate more of the fund to property and less to cash for unanticipated redemptions, so the funds could operate in a more stable and sustainable way.
HOW DOES THE PROPOSAL INTERACT WITH HMRC?
The introduction of the proposed notice period could mean that relevant funds might no longer be qualifying investments for stocks and shares ISAs. The FCA are liaising with the Treasury and HMRC to confirm whether these funds would remain eligible for ISAs following a change in the rules for property funds. The FCA has commented that it will take this into account in its final decision in respect of whether to introduce notice periods or not.
The FCA has also commented that they are open to learn of other examples of potential unintended consequences as a result of the proposed changes, for example the emergence of secondary markets for units in property funds.
The Consultation remains open to responses until 3 November 2020 and affected firms are encouraged to email or write to the FCA with their evaluation and suggestions. The FCA also continues to engage with other stakeholders on considering new initiatives within the regulatory framework that would facilitate investments in long-term assets. The FCA is aiming to publish a policy statement with final rules as soon as possible in early 2021, with the objective of striking a balance to enable funds to operate both efficiently and fairly to the benefit of all investors.
To view the FCA’s Consultation in greater detail, please click here.
For more information, and any guidance or advice on understanding your requirements under the proposed new rules, Cleveland & Co External In-house counselTM, your specialist outsourced legal team, are here to help.